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EX-32.1 - CERTIFICATION OF PRINCIPAL EXECUTIVE OFFICER OF THE COMPANY, PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 - China Xuefeng Environmental Engineering Inc.exh321.htm
EX-31.1 - CERTIFICATION OF PRINCIPAL EXECUTIVE OFFICER PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 - China Xuefeng Environmental Engineering Inc.exh311.htm
EX-31.2 - CERTIFICATION OF PRINCIPAL FINANCIAL OFFICER PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 - China Xuefeng Environmental Engineering Inc.exh312.htm
EX-32.2 - CERTIFICATION OF PRINCIPAL FINANCIAL OFFICER OF THE COMPANY, PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 - China Xuefeng Environmental Engineering Inc.exh322.htm

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

Form 10-Q

(Mark One)

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended February 29, 2016
or

rTRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Transition Period from ___________ to _____________

Commission File Number: 333-175483

China Xuefeng Environmental Engineering Inc.
(Exact name of registrant as specified in its charter)

Nevada
99-0364975
(State or other jurisdiction of incorporation or organization)
(I.R.S. Employer Identification No.)
 
 
 The Beijing-Hangzhou Grand Canal Service Center
Building C, Suite 214
 Sucheng District, Suqian, Jiangsu Province, P.R. China
223800
(Address of principal executive offices)
(Zip Code)

+86 (527) 8437-0508
(Registrant's telephone number, including area code)

Not Applicable
(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes No 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of "large accelerated filer," "accelerated filer," and "smaller reporting company" in Rule 12b-2 of the Exchange Act.

Large accelerated filer
 
Accelerated filer
 
 
 
 
 
Non-accelerated filer
(Do not check if a smaller reporting company)
Smaller reporting company

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No 

As of April 12, 2016, there were 55,200,000 outstanding shares of common stock of the registrant, par value $0.001 per share.

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC.
QUARTERLY REPORT ON FORM 10-Q

February 29, 2016

TABLE OF CONTENTS
 

 
PART IFINANCIAL INFORMATION
Page
 
 
 
Item 1.
Financial Statements.
 3
 
 
 
Item 2.
Management's Discussion and Analysis of Financial Condition and Results of Operations.
 34
 
 
 
Item 3.
Quantitative and Qualitative Disclosures About Market Risk.
 42
 
 
 
Item 4.
Controls and Procedures.
 43
 
 
 
 
PART IIOTHER INFORMATION
 
 
 
 
Item 1.
Legal Proceedings.
 44
 
 
 
Item 1A.
Risk Factors.
 44
 
 
 
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds.
 44
 
 
 
Item 3.
Defaults Upon Senior Securities.
 44
 
 
 
Item 4.
Mine Safety Disclosures.
 44
 
 
 
Item 5.
Other Information.
 44
 
 
 
Item 6.
Exhibits.
 44
 
 
 
Signatures
 45
 
1

CERTAIN USAGE OF TERMS

Except as otherwise indicated by the context, references in this report to "we," "us," "our," "our Company," or "the Company" are to the combined business of China Xuefeng Environmental Engineering Inc.

CAUTIONARY STATEMENT ON FORWARD-LOOKING INFORMATION

This Quarterly Report on Form 10-Q contains "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933, as amended (the "Securities Act"), and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). Forward-looking statements discuss matters that are not historical facts. Because they discuss future events or conditions, forward-looking statements may include words such as "anticipate," "believe," "estimate," "intend," "could," "should," "would," "may," "seek," "plan," "might," "will," "expect," "anticipate," "predict," "project," "forecast," "potential," "continue" negatives thereof or similar expressions. Forward-looking statements speak only as of the date they are made, are based on various underlying assumptions and current expectations about the future and are not guarantees. Such statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, level of activity, performance or achievement to be materially different from the results of operations or plans expressed or implied by such forward-looking statements.

We cannot predict all of the risks and uncertainties. Accordingly, such information should not be regarded as representations that the results or conditions described in such statements or that our objectives and plans will be achieved and we do not assume any responsibility for the accuracy or completeness of any of these forward-looking statements. These forward-looking statements are found at various places throughout this Quarterly Report on Form 10-Q and include information concerning possible or assumed future results of our operations, including statements about potential acquisition or merger targets; business strategies; future cash flows; financing plans; plans and objectives of management; any other statements regarding future acquisitions, future cash needs, future operations, business plans and future financial results, and any other statements that are not historical facts.

These forward-looking statements represent our intentions, plans, expectations, assumptions and beliefs about future events and are subject to risks, uncertainties and other factors. Many of those factors are outside of our control and could cause actual results to differ materially from the results expressed or implied by those forward-looking statements. In light of these risks, uncertainties and assumptions, the events described in the forward-looking statements might not occur or might occur to a different extent or at a different time than we have described. You are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of the Quarterly Report on Form 10-Q. All subsequent written and oral forward-looking statements concerning other matters addressed in this Quarterly Report on Form 10-Q and attributable to us or any person acting on our behalf are expressly qualified in their entirety by the cautionary statements contained or referred to in this Quarterly Report on Form 10-Q.

Except to the extent required by law, we undertake no obligation to update or revise any forward-looking statements, whether as a result of new information, future events, a change in events, conditions, circumstances or assumptions underlying such statements, or otherwise.
 
2

 
PART I—FINANCIAL INFORMATION

Item 1. Financial Statements.

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
Consolidated Financial Statements for the Three and
Nine Months Ended February 29, 2016 and 2015
  
CONTENTS
PAGE
 
 
CONSOLIDATED FINANCIAL STATEMENTS:
 3
 
 
Consolidated Balance Sheets as of February 29, 2016 (unaudited) and May 31, 2015
 4
 
 
Consolidated Statements of Income and Comprehensive Income for the Three and Nine Months Ended February 29, 2016 and 2015
 6
 
 
Consolidated Statements of Cash Flows for the Three and Nine Months Ended February 29, 2016 and 2015
8
 
 
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
9

3

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS (IN U.S. $)

   
February 29,
   
May 31,
 
ASSETS
 
2016
   
2015
 
   
(Unaudited)
     
Current assets:        
  Cash   $ 6,639,055    
$
26,373,379
 
  Accounts receivable
   
4,137,447
     
-
 
  Prepaid VAT
   
1,612,979
     
-
 
  Prepaid expenses
   
123,633
     
98,510
 
                 
    Total current assets
   
12,513,114
     
26,471,889
 
                 
Fixed assets, net
   
12,854,789
     
16,118
 
                 
Accounts receivable-non-current
   
7,002,630
     
-
 
                 
TOTAL ASSETS
 
$
32,370,533
   
$
26,488,007
 
 
See accompanying notes to the consolidated financial statements
 

4

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS (IN U.S. $)
 
   
February 29,
   
May 31,
 
LIABILITIES AND STOCKHOLDERS' EQUITY
 
2016
   
2015
 
    (Unaudited)      
Current liabilities:
       
  Accounts payable
 
$
946,123
   
$
-
 
  Deferred revenues
   
2,278,827
     
2,204,550
 
  Taxes payable
   
747,096
     
652,386
 
  Loan from stockholder
   
451,520
     
380,073
 
  Accrued liabilities
   
66,067
     
53,310
 
    Total current liabilities
   
4,489,633
     
3,290,319
 
                 
Security deposits payable
   
2,075,360
     
-
 
                 
TOTAL LIABILITIES
   
6,564,993
     
3,290,319
 
                 
Stockholders' equity:
               
  Common stock, $0.001 par value per share, 75,000,000 shares authorized; 55,200,000 shares issued and outstanding
   
55,200
     
55,200
 
  Additional paid-in capital
   
11,389,049
     
11,389,049
 
  Statutory reserve fund
   
1,510,998
     
1,077,045
 
  Retained earnings
   
12,922,359
     
9,301,878
 
  Other comprehensive income
   
(1,018,301
)
   
582,259
 
                 
  Stockholders' equity before noncontrolling interests
   
24,859,305
     
22,405,431
 
  Noncontrolling interest
   
946,235
     
792,257
 
                 
    Total stockholders' equity
   
25,805,540
     
23,197,688
 
                 
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY
 
$
32,370,533
   
$
26,488,007
 
 
See accompanying notes to the consolidated financial statements
 
5

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME
FOR THE THREE AND NINE MONTHS ENDED  FEBRUARY 29, 2016 AND FEBRUARY 28, 2015
(UNAUDITED) (IN U.S. $)
   
Three Months Ended
   
Nine Months Ended
 
   
February 29,
2016
   
February 28,
2015
   
February 29,
2016
 
February 28,
2015
 
Revenue:
             
    Sales
 
$
1,808,940
   
$
1,950,000
   
$
18,735,911
   
$
3,705,000
 
    Lease income
   
340,667
     
-
     
394,120
     
-
 
                                 
Total revenue
   
2,149,607
     
1,950,000
     
19,130,031
     
3,705,000
 
                                 
Cost of goods sold:
                               
    Cost of sales
   
147,030
     
95,119
     
12,058,881
     
249,936
 
    Depreciation expense - leased equipment
   
165,830
     
-
     
191,879
     
-
 
                                 
Total cost of goods sold
   
312,860
     
95,119
     
12,250,760
     
249,936
 
Gross profit  
 1,836,747
     
1,854,881
     
6,879,271
   
 3,455,064
 
                                 
Operating expenses:
                               
    Selling and marketing
   
344,441
     
25,795
     
907,819
     
76,407
 
General and administrative  
 191,527
     
98,755
     
525,970
   
 280,432
 
Total operating expenses  
 535,968
     
124,550
     
1,433,789
   
 356,839
 

 
See accompanying notes to the consolidated financial statements.
 
6

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME
FOR THE THREE AND NINE MONTHS ENDED  FEBRUARY 29, 2016 AND FEBRUARY 28, 2015
(UNAUDITED) (IN U.S. $)
   
Three Months Ended
   
Nine Months Ended
 
   
February 29,
2016
   
February 28,
2015
   
February 29,
2016
 
February 28,
2015
 
 
             
Income from operations    
1,300,779
     
1,730,331
   
 
5,445,482
     
3,098,225
 
   Interest income
   
161,052
     
18,816
     
267,558
     
55,284
 
                                 
Income before provision for income taxes
   
1,461,831
     
1,749,147
     
5,713,040
     
3,153,509
 
Provision for income taxes     371,708       437,287       1,446,510       788,384  
                                 
Net income
    1,090,123       1,311,860       4,266,530   2,365,125       
Noncontrolling interest
   
(54,171
)    
(63,916
)    
(212,096
)    
(113,229
)
                                 
Net income attributable to common stockholders
 
$
1,035,952
   
$
1,247,944
   
$
4,054,434
   
$
2,251,896
 
                                 
Earnings per common share, basic and diluted   $ 0.02     $ 0.02     $ 0.07     $ 0.04  
                                 
Weighted average shares outstanding, basic and diluted
   
55,200,000
     
55,200,000
     
55,200,000
     
55,200,000
 
                                 
Comprehensive Income:
                               
Net Income   $ 1,090,123     $ 1,311,860     $ 4,266,530     $ 2,365,125  
Foreign currency translation adjustment
    (553,887 )     (99,691 )     (1,658,678 )     5,585  
                                 
Comprehensive income
   
536,236
     
1,212,169
     
2,607,852
     
2,370,710
 
Comprehensive income attributable to noncontrolling interests    
 (54,171
)    
(60,762
)    
(153,978
)    
 (113,294 
)
Net Comprehensive income attributable to common stockholders   $ 482,065     $
1,151,407
    $
2,453,874
    $
 2,257,416 
 

 
See accompanying notes to the consolidated financial statements.
7


CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
FOR THE NINE MONTHS ENDED FEBRUARY 29, 2016 (UNAUDITED) (IN U.S. $)

   
Common
Stock
   
Additional
Paid-in
Capital
   
Retained
Earnings
   
Non-
Controlling
Interests
   
Statutory
Reserve
Fund
   
Other
Comprehensive
Income
   
Total
 
                                                         
Balance, May 31, 2015
 
$
55,200
   
$
11,389,049
   
$
9,301,878
   
$
792,257
   
$
1,077,045
   
$
582,259
   
$
23,197,688
 
                                                         
   Net income
   
-
     
-
     
4,054,434
     
212,096
     
-
     
-
     
4,266,530
 
   Appropriation to statutory reserve fund
   
-
     
-
     
(433,953
)
   
-
     
433,953
     
-
     
-
 
    Foreign currency
           translation adjustment
   
-
     
-
     
-
     
(58,118
)
   
-
     
(1,600,560
)
   
(1,658,678
)
Balance, February 29, 2016 (Unaudited)
 
$
55,200
   
$
11,389,049
   
$
12,922,359
   
$
946,235
   
$
1,510,998
   
$
(1,018,301
)
 
$
25,805,540
 

 
See accompanying notes to the consolidated financial statements.
 
8

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE NINE MONTHS ENDED FEBRUARY 29, 2016 AND FEBRUARY 28, 2015
(UNAUDITED) (IN U.S. $)
      
For The Nine Months Ended
 
      
February 29,
2016
   
February 28,
2015
 
         
Cash flows from operating activities:                
Net income
 
$
4,266,530
   
$
2,365,125
 
  Adjustments to reconcile net income to net cash provided by operating activities:
               
  Depreciation
   
222,049
     
9,162
 
      Changes in operating assets and liabilities:
               
       (Increase) in accounts receivable
   
(11,140,077
)
   
-
 
       (Increase) in prepaid VAT
   
(1,612,979
)
   
-
 
       (Increase) in prepaid expenses
   
(25,123
)
   
(33,533
)
        Increase in accounts payable
   
301,197
     
-
 
        Increase in deferred revenue
   
74,277
     
292,950
 
        Increase in security deposits payable
   
2,075,360
     
-
 
        Increase in taxes payable
   
94,710
     
193,355
 
        Increase (decrease) in accrued liabilities
   
98,757
     
(49,830
)
                 
              Net cash (used in) provided by operating activities
   
(5,645,299
)
   
2,777,229
 
                 
Cash flows from investing activities:
               
Purchase of equipment
   
(12,803,897
)
   
-
 
Effect of exchange rate changes on cash
   
(1,285,128
)
   
121,481
 
                 
Net (decrease) increase in cash
   
(19,734,324
)
   
2,898,710
 
Cash, beginning
   
26,373,379
     
20,629,604
 
                 
Cash, end
 
$
6,639,055
   
$
23,528,314
 
                 
Supplemental disclosure of cash flow information
               
Cash paid during the period for:
               
Interest
 
$
-
   
$
-
 
Income taxes
   
1,309,525
     
599,383
 
                 
Noncash financing activities
               
      Payment of accrued liabilities by shareholder in the form of loan
 
$
86,000
   
$
120,000
 
      Accrued capital expenditures
   
644,923
     
-
 

See accompanying notes to the consolidated financial statements.
 
9

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND NINE MONTHS ENDED FEBRUARY 29, 2016 AND FEBRUARY 28, 2015 (UNAUDITED) (IN U.S. $)


NOTE 1.   ORGANIZATION
China Xuefeng Environmental Engineering Inc. (the "Company"), formerly known as NYC Moda Inc., was incorporated under the laws of the State of Nevada on March 30, 2011.  Since its inception until the closing of the Exchange Agreement, the Company was a development-stage company.
On November 27, 2012, the Company completed a reverse acquisition transaction through a share exchange with the stockholders of Inclusion Business Limited ("Inclusion"), whereby the Company acquired 100% of the outstanding shares of Inclusion in exchange for 7,895,000 shares of its common stock, representing 76.65% of the issued and outstanding shares of common stock.  As a result of the reverse acquisition, Inclusion became the Company's wholly-owned subsidiary and the former Inclusion Stockholders became our controlling stockholders.  The share exchange transaction was treated as a reverse acquisition, with Inclusion as the acquirer and the Company as the acquired party for accounting purposes.
In November, 2012, the Company filed a certificate of amendment to its articles of incorporation to change its name from "NYC Moda, Inc." to "China Xuefeng Environmental Engineering Inc." (the "Name Change") and to initiate a 4-for-1 forward stock split (the "Forward Split") of its outstanding shares of common stock. The Name Change and the Forward Split were effective in December, 2012. Upon the effectiveness of the Forward Split, the number of outstanding shares of the Company's common stock increased from 10,300,000 to 41,200,000 shares. In March, 2013, the Company sold 14,000,000 shares of common stock to 12 unrelated individuals in a private offering, generating $7,000,000 in net proceeds.
As a result of the transaction with Inclusion, the Company owns all of the issued and outstanding common stock of Lotus International Holdings Limited ("Lotus"), a wholly-owned subsidiary of Inclusion, which in turn owns all of the issued and outstanding capital stock of Baichuang Information Consulting (Shenzhen) Co. Ltd ("Baichuang Consulting"). In addition, the Company effectively and substantially controls Jiangsu Xuefeng Environmental Protection Science and Technology Co., Ltd. ("Jiangsu Xuefeng") through a series of captive agreements with Baichuang Consulting.
The Company conducts its operations through its controlled consolidated variable interest entity ("VIE"), Jiangsu Xuefeng.  Jiangsu Xuefeng, incorporated under the laws of the People's Republic of China ("PRC") in December, 2007, is primarily engaged in the sale, lease and installation of garbage recycling equipment and provides improvement and upgrading services of garbage recycling processing technology and equipment. 
In October, 2012, Baichuang Consulting (the "WFOE"), a wholly-owned subsidiary of Lotus, entered into a series of contractual arrangements (the "VIE Agreements"). The VIE Agreements include (i) an Exclusive Technical Service and Business Consulting Agreement; (ii) a Proxy Agreement, (iii) Share Pledge Agreement and, (iv) Call Option Agreement with the stockholders of Jiangsu Xuefeng.
10

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND NINE MONTHS ENDED FEBRUARY 29, 2016 AND FEBRUARY 28, 2015 (UNAUDITED) (IN U.S. $)


NOTE 1.   ORGANIZATION (CONTINUED)
Exclusive Technical Service and Business Consulting Agreement: Pursuant to the Exclusive Technical Service and Business Consulting Agreement, the WFOE provides technical support, consulting, training, marketing and operational consulting services to Jiangsu Xuefeng. In consideration for such services, Jiangsu Xuefeng has agreed to pay an annual service fee to the WFOE of 95% of Jiangsu Xuefeng's annual net income and an additional payment of approximately US$15,910 (RMB 100,000) each month. The Agreement has an unlimited term and only can be terminated upon written notice agreed to by both parties.
Proxy Agreement: Pursuant to the Proxy Agreement, the stockholders of Jiangsu Xuefeng agreed to irrevocably entrust the WFOE to designate a qualified person acceptable under PRC law and foreign investment policies, all of the equity interests in Jiangsu Xuefeng held by the stockholders of Jiangsu Xuefeng. The Agreement has an unlimited term and only can be terminated upon written notice agreed to by both parties.
Call Option Agreement: Pursuant to the Call Option agreement, the WFOE has an exclusive option to purchase, or to designate a purchaser, to the extent permitted by PRC law and foreign investment policies, part or all of the equity interests in Jiangsu Xuefeng held by each of the stockholders. To the extent permitted by PRC laws, the purchase price for the entire equity interest is approximately US$0.16 (RMB1.00) or the minimum amount required by PRC law or government practice. This Agreement remains effective until all the call options under the Agreement have been exercised by Baichuang Consulting or its designated entities or natural persons.
Share Pledge Agreement: Pursuant to the Share Pledge agreement, each of the stockholders pledged their shares in Jiangsu Xuefeng to the WFOE, to secure their obligations under the Exclusive Technical Service and Business Consulting Agreement. In addition, the stockholders of Jiangsu Xuefeng agreed not to transfer, sell, pledge, dispose of or create any encumbrance on their interests in Jiangsu Xuefeng that would affect the WFOE's interests. This Agreement remains effective until the obligations under the Exclusive Technical Service and Business Consulting Agreement, Call Option Agreement and Proxy Agreement have been fulfilled or terminated.
As a result of the entry into the foregoing agreements, the Company has a corporate structure which is set forth as follows:

11

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND NINE MONTHS ENDED FEBRUARY 29, 2016 AND FEBRUARY 28, 2015 (UNAUDITED) (IN U.S. $)

NOTE 1.   ORGANIZATION (CONTINUED)


NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BASIS OF ACCOUNTING AND PRESENTATION
The accompanying consolidated financial statements have been prepared on the accrual basis of accounting.  The consolidated financial statements for the three and nine months ended February 29, 2016 and February 28, 2015 include China Xuefeng Environmental Engineering Inc., and its wholly owned subsidiaries, Inclusion, Lotus and Baichuang Consulting and its VIE, Jiangsu Xuefeng.  All significant intercompany accounts and transactions have been eliminated in consolidation when applicable.

12

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND NINE MONTHS ENDED FEBRUARY 29, 2016 AND FEBRUARY 28, 2015 (UNAUDITED) (IN U.S. $)
 

NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
BASIS OF ACCOUNTING AND PRESENTATION (CONTINUED)
The unaudited interim consolidated financial statements of the Company as of February 29, 2016 and for the three and nine months ended February 29, 2016 and February 28, 2015, have been prepared in accordance with accounting principles generally accepted in the United States of America and the rules and regulations of the SEC which apply to interim financial statements. Accordingly, they do not include all of the information and footnotes normally required by accounting principles generally accepted in the United States of America for annual financial statements. In the opinion of management, such information contains all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of the results for the periods presented. The interim consolidated financial information should be read in conjunction with the consolidated financial statements and the notes thereto, included in the Company's Form 10-K filed with the SEC. The results of operations for the three and nine months ended February 29, 2016 and February 28, 2015 are not necessarily indicative of the results to be expected for future quarters or for the year ending May 31, 2016.
All consolidated financial statements and notes to the consolidated financial statements are presented in United States dollars ("US Dollar" or "US$" or "$").
VARIABLE INTEREST ENTITY
Pursuant to Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") 810, "Consolidation" ("ASC 810"), the Company is required to include in its consolidated financial statements, the financial statements of its variable interest entities ("VIEs").  ASC 810 requires a VIE to be consolidated by a company if that company is subject to a majority of the risk of loss for the VIE or is entitled to receive a majority of the VIE's residual returns.  VIEs are those entities in which a company, through contractual arrangements, bears the risk of, and enjoys the rewards normally associated with ownership of the entity, and therefore the company is the primary beneficiary of the entity.
Under ASC 810, a reporting entity has a controlling financial interest in a VIE, and must consolidate that VIE, if the reporting entity has both of the following characteristics: (a) the power to direct the activities of the VIE that most significantly affect the VIE's economic performance; and (b) the obligation to absorb losses, or the right to receive benefits, that could potentially be significant to the VIE.  The reporting entity's determination of whether it has this power is not affected by the existence of kick-out rights or participating rights, unless a single enterprise, including its related parties and de facto agents, have the unilateral ability to exercise those rights.  Jiangsu Xuefeng's actual stockholders do not hold any kick-out rights that affect the consolidation determination.
Through the VIE agreements disclosed in Note 1, the Company is deemed the primary beneficiary of Jiangsu Xuefeng. Accordingly, the results of Jiangsu Xuefeng have been included in the accompanying consolidated financial statements. Jiangsu Xuefeng has no assets that are collateral for or restricted solely to settle their obligations. The creditors of Jiangsu Xuefeng do not have recourse to the Company's general credit.
13

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND NINE MONTHS ENDED FEBRUARY 29, 2016 AND FEBRUARY 28, 2015 (UNAUDITED) (IN U.S. $)


NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
VARIABLE INTEREST ENTITY (CONTINUED)
The following financial statement amounts and balances of Jiangsu Xuefeng have been included in the accompanying consolidated financial statements.
 
ASSETS
 
February 29,
 2016
   
May 31,
2015
 
   
(Unaudited)
     
Current assets:
       
 Cash
 
$
6,451,426
   
$
26,166,628
 
 Accounts receivable
   
4,137,447
     
-
 
 Prepaid VAT
   
1,612,979
     
-
 
 Prepaid expenses
   
122,648
     
97,526
 
                 
  Total current assets
   
12,324,500
     
26,264,154
 
                 
Fixed assets, net
   
12,854,789
     
16,118
 
                 
Account receivable-non-current
   
7,002,630
     
-
 
                 
TOTAL ASSETS
 
$
32,181,919
   
$
26,280,272
 
                 
LIABILITIES
               
                 
Current liabilities:
               
 Due to China Xuefeng Environmental Engineering, Inc. (1)
 
$
6,639,718
   
$
7,105,281
 
 Payable to WFOE (2)
   
12,459,429
     
9,418,509
 
 Accounts payable
   
946,120
     
-
 
 Deferred revenue
   
2,278,827
     
2,204,550
 
 Taxes payable
   
583,929
     
516,371
 
 Loan from stockholder
   
278,173
     
297,678
 
 Accrued liabilities
   
43,067
     
17,310
 
                 
  Total current liabilities
   
23,229,263
     
19,559,699
 
                 
Deposit payable-noncurrent
   
2,075,360
     
-
 
                 
TOTAL LIABILITIES
 
$
25,304,623
   
$
19,559,699
 

14

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND NINE MONTHS ENDED FEBRUARY 29, 2016 AND FEBRUARY 28, 2015 (UNAUDITED) (IN U.S. $)
 
NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
VARIABLE INTEREST ENTITY (CONTINUED)

(1)
Due to China Xuefeng Environmental Engineering, Inc. is for the proceeds from the sale of common stock which proceeds were received by Jiangsu Xuefeng for 14,000,000 common shares issued by China Xuefeng Environmental Engineering, Inc. on March 19, 2013 at $0.50 each (approximately US$7,000,000).

(2)
Payable to WFOE represents outstanding amounts due to Baichuang Information Consulting (Shenzhen) Co. Ltd. under the Exclusive Technical Service and Business Consulting Agreement for consulting services provided to Jiangsu Xuefeng in exchange for 95% of Jiangsu Xuefeng's net income and additional monthly payments of RMB 100,000 (approximately US$15,910).  During the nine months ended February 29, 2016 and February 28 2015, Jiangsu Xuefeng did not make any payment to the WOFE.

   
For The Three Months Ended
 
   
February 29,
2016
 
February 28,
2015
 
   
(unaudited)
 
(unaudited)
 
       
Revenue
 
$
2,149,607
   
$
1,950,000
 
                 
Net income (3)
 
$
1,083,417
   
$
1,278,288
 


   
For The Nine Months Ended
 
   
February 29,
2016
 
February 28,
2015
 
   
(unaudited)
 
(unaudited)
 
       
Revenue
 
$
19,130,031
   
$
3,075,000
 
                 
Net income (3)
 
$
4,241,923
   
$
2,264,580
 

15

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND NINE MONTHS ENDED FEBRUARY 29, 2016 AND FEBRUARY 28, 2015 (UNAUDITED) (IN U.S. $)
 
NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
VARIABLE INTEREST ENTITY (CONTINUED)
(3)
Under the Exclusive Technical Service and Business Consulting Agreement, 95% of the net income is to be remitted to the WFOE, which is not reflected above.

   
For The Nine Months Ended
 
   
February 29,
2016
   
February 28,
2015
 
   
(Unaudited)
   
(Unaudited)
 
         
Net cash (used in) provided by operating activities
 
$
(5,651,977
)
 
$
2,902,034
 
Net cash (used in) investing activities
   
(12,803,897
)
   
-
 
Net cash provided by financing activities
   
-
     
-
 
Effect of exchange rate changes on cash
   
(1,259,328
)
   
3,938
 
                 
Net (decrease) increase in cash
 
$
(19,715,202
)
 
$
2,905,972
 

The Company believes that Baichuang Consulting's contractual agreements with Jiangsu Xuefeng are in compliance with PRC law and are legally enforceable.  The stockholders of Jiangsu Xuefeng are also the senior management of the Company and therefore the Company believes that they have no current interest in seeking to act contrary to the contractual arrangements.  However, Jiangsu Xuefeng and its stockholders may fail to take certain actions required for the Company's business or to follow the Company's instructions despite their contractual obligations to do so.  Furthermore, if Jiangsu Xuefeng or its stockholders do not act in the best interests of the Company under the contractual arrangements and any dispute relating to these contractual arrangements remains unresolved, the Company will have to enforce its rights under these contractual arrangements through PRC law and courts and therefore will be subject to uncertainties in the PRC legal system.  All of these contractual arrangements are governed by PRC law and provide for the resolution of disputes through arbitration in the PRC.  Accordingly, these contracts would be interpreted in accordance with PRC law and any disputes would be resolved in accordance with PRC legal procedures.  As a result, uncertainties in the PRC legal system could limit the Company's ability to enforce these contractual arrangements, which may make it difficult to exert effective control over Jiangsu Xuefeng, and its ability to conduct the Company's business may be adversely affected.
USE OF ESTIMATES
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect certain reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods.  Actual results could differ from those estimates.
16

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND NINE MONTHS ENDED FEBRUARY 29, 2016 AND FEBRUARY 28, 2015 (UNAUDITED) (IN U.S. $)

NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
FOREIGN CURRENCY TRANSLATION
Almost all Company assets are located in the PRC.  The functional currency for the majority of the Company's operations is the Renminbi ("RMB").  The Company uses the United States dollar ("US Dollar" or "US$" or "$") for financial reporting purposes.  The financial statements of the Company have been translated into US dollars in accordance with FASB ASC 830, "Foreign Currency Matters."
All asset and liability accounts have been translated using the exchange rate in effect at the balance sheet date.  Equity accounts have been translated at their historical exchange rates when the capital transactions occurred.  Statements of income amounts have been translated using the average exchange rate for the periods presented.  Adjustments resulting from the translation of the Company's financial statements are recorded as other comprehensive income (loss).
The exchange rates used to translate amounts in RMB into US dollars for the purposes of preparing the financial statements are as follows:
   
February 29,
2016
   
May 31,
2015
 
   
(Unaudited)
     
         
Balance sheet items, except for stockholders' equity, as of period end
   
0.1526
     
0.1633
 

   
For The Three Months Ended
 
   
February 29,
2016
   
February 28,
2015
 
   
(Unaudited)
   
(Unaudited)
 
         
Amounts included in the statements of income, changes in stockholders' equity and cash flows
   
0.1533
     
0.1627
 

   
For The Nine Months Ended
 
   
February 29,
2016
   
February 28,
2015
 
   
(Unaudited)
   
(Unaudited)
 
         
Amounts included in the statements of income, changes in stockholders' equity and cash flows
   
0.1572
     
0.1625
 

17

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND NINE MONTHS ENDED FEBRUARY 29, 2016 AND FEBRUARY 28, 2015 (UNAUDITED) (IN U.S. $)
 
NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
FOREIGN CURRENCY TRANSLATION (CONTINUED)
For the three months ended February 29, 2016 and February 28, 2015, foreign currency translation adjustments of $(553,887) and $(99,691), respectively, and for the nine months ended February 29, 2016 and February 28, 2015, foreign currency translation adjustments of $(1,658,678) and $5,585, respectively, have been reported as other comprehensive income.  Other comprehensive income of the Company consists entirely of foreign currency translation adjustments.  Pursuant to ASC 740-30-25-17, "Exceptions to Comprehensive Recognition of Deferred Income Taxes," the Company does not recognize deferred U.S. taxes related to the undistributed earnings of its foreign subsidiaries and, accordingly, recognizes no income tax expense or benefit from foreign currency translation adjustments.
Although government regulations now allow convertibility of the RMB for current account transactions, significant restrictions still remain.  Hence, such translations should not be construed as representations that the RMB could be converted into US dollars at that rate or any other rate.
The value of the RMB against the US dollar and other currencies may fluctuate and is affected by, among other things, changes in the PRC's political and economic conditions.  Any significant revaluation of the RMB may materially affect the Company's financial condition in terms of US dollar reporting. The PRC government in August 2015 devalued the RMB by approximately 3.5%.
REVENUE RECOGNITION
Revenues are primarily derived from selling and leasing garbage processing equipment, providing garbage recycling processing system technology support, renovation and upgrade services and patent licensing to customers.  The Company's revenue recognition policies comply with FASB ASC 605 "Revenue Recognition."  In general, the Company recognizes revenue when there is persuasive evidence of an arrangement, the fee is fixed or determinable, the products or services have been delivered or performed and collectability of the resulting receivable is reasonably assured.
Sales-Type Leases
The Company entered into three sales-type lease arrangements during the quarter ended August 31, 2015, with two customers for financing of their purchase of garbage processing equipment.  The arrangements with the customers have a fixed term of three years. Revenue from the sale of the equipment is recognized at the inception of the lease. The payments have been present valued with an annual interest rate of 5.25%. In connection with these arrangements, the Company recognized revenue of $14,381,471 for the nine months ended February 29, 2016. There were no sales during the three months ended February 29, 2016. Future minimum collections (principal and interest) for the years ending May 31 are as follows:

18

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND NINE MONTHS ENDED FEBRUARY 29, 2016 AND FEBRUARY 28, 2015 (UNAUDITED) (IN U.S. $)
 
NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
REVENUE RECOGNITION (CONTINUED)
Sales-Type Leases (Continued)
Year Ending
   
May 31,
 
Amount
 
     
2016
 
$
1,013,581
 
2017
   
4,189,113
 
2018
   
4,413,410
 
2019
   
1,521,371
 
         
   
$
11,137,475
 
 
Operating Leases

The Company entered into two operating lease arrangements with two customers for garbage processing equipment on December 28, 2015 and November 6, 2015, respectively. The arrangement with the customer has a fixed term of five years with quarterly payments of $152,600 and $366,240, respectively. Revenue from the leasing of the equipment is recognized monthly. In addition, the lease required a security deposit on $610,400 and $1,464,960, respectively. At the end of the five years lease term, it will be determined whether the lease will be extended, leased to a new customer or returned to the Company. Future minimum payments for the years ending May 31 are as follows:
Year Ending
   
May 31,
 
Amount
 
     
2016
 
$
569,707
 
2017
   
2,075,360
 
2018
   
2,075,360
 
2019
   
2,075,360
 
2020
   
2,075,360
 
2021
   
1,922,760
 
         
   
$
10,793,907
 
The Company entered into a new operating lease arrangement with a customer for garbage processing equipment on January 18, 2016. The arrangement with the customer has a fixed term of five years with quarterly payments of $183,120. Revenue from the leasing of the equipment is recognized monthly. In addition, the lease required a security deposit on $732,480. The equipment was not delivered and accepted during the quarter, accordingly no revenue was recognized.

19

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND NINE MONTHS ENDED FEBRUARY 29, 2016 AND FEBRUARY 28, 2015 (UNAUDITED) (IN U.S. $)
 
NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
REVENUE RECOGNITION (CONTINUED)
Multiple-Element Arrangements
In October 2009, the FASB issued Accounting Standards Update ("ASU") No. 2009-13, "Multiple Deliverable Revenue Arrangements." ASU No. 2009-13 amended the guidance on arrangements with multiple deliverables under ASC 605-25, "Revenue Recognition—Multiple-Element Arrangements."  To qualify as a separate unit of accounting under ASC 605-25, the delivered item must have value to the customer on a standalone basis.  The significant deliverables under the Company's multiple-element arrangements are improvement and upgrade services and patent licensing.
Improvement and Upgrade Service
The improvement and upgrade service is a one-time service.  An inspection is conducted by the customer according to industry standards within three days of the completion of the improvement and upgrade.  An acceptance form is provided by the customer if the inspection is satisfactory.  Performance testing is conducted on the upgraded equipment within one month. A final evaluation report is provided within five days of the completion of the performance testing.  The fee for improvement and upgrade services is fixed and becomes due within 30 days, upon the signing of the contract.  If the performance testing does not meet the specifications as agreed to in the contract, the customer is refunded 20% of the fee for the improvement and upgrade services.
The Company has met the agreed upon specifications and has not been required to make any refunds for its services.  No warranty is provided by the Company.
The customer is responsible for repair services when necessary.  The out of pocket expenses for the repair services will be charged separately to the customer by the Company.
Patent Licensing
Patent licensing is limited to 5 years with payments due annually in advance.  The patent technology of "harmless and comprehensive garbage processing equipment" provided by the Company to its customers has high garbage processing capacity and stable operation capacity.  It is the first modern system equipment in China to use DCS (Distributed Control System) centralized control, by which mechanical automation will be realized for the comprehensive treatment of life garbage.  Its core technology is to organically integrate the anaerobic digestion and aerobic fermentation garbage process, degrade and transform the organic matter of domestic waste, effectively sort out the garbage and recycle all kinds of materials, to eventually realize the true waste resource utilization and harmless utilization, with a utilization rate approaching 100%.  The resource recovery products, biogas, not only can be used for meeting the needs of the plant itself, but also can be sold as a separate product, which greatly improves the efficiency of garbage processing of the customer's equipment, decreases production cost, and increases the recovery return of garbage processing.

20

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND NINE MONTHS ENDED FEBRUARY 29, 2016 AND FEBRUARY 28, 2015 (UNAUDITED) (IN U.S. $)
 
NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
REVENUE RECOGNITION (CONTINUED)
Multiple-Element Arrangements (Continued)
Patent Licensing (Continued)
The Company's customer who pays for an upgrade and improvement fee is not required to enter into a licensing agreement to continue to use the patented technology.  If the customer does not require the garbage processing equipment to reach the level of the patented technology which can process 500 tons to 1,000 tons of garbage per day, then the customer does not need to enter into the patent licensing agreement.
Multiple Elements
The Company determined that its improvement and upgrade services are individually a separate unit of accounting.  In determining whether the improvement and upgrade services has standalone value, the Company considered factors including the availability of similar services from other vendors, its fee structure based on inclusion and exclusion of the service, and its marketing and delivery of the services.  The Company uses the vendor-specific objective evidence to determine the selling price for its improvement and upgrade services when sold in multiple-element arrangements.  Although not yet being sold separately, the price established by the management has the relevant authority.
The Company also determined that the patent licensing has standalone value because the patent can be licensed separately. The Company uses the vendor-specific objective evidence to determine the price for patent licensing when sold in multiple-element arrangements.  Although not yet being licensed separately, the price established by the management has the relevant authority.
The Company allocates the arrangement consideration based on their relative selling prices.  Revenues for the improvement and upgrade services are recognized when completed, the performance testing is passed and the final evaluation report is provided by the customer, which generally is within 30 days, assuming all other revenue recognition criteria are met.  Revenues for patent licensing are recognized monthly over the licensing period.
The Company believes the effect of changes in the selling price for improvement and upgrade services and patent licensing will not have significant effect on the allocation of the arrangement.
FAIR VALUE OF FINANCIAL INSTRUMENTS
FASB ASC 820, "Fair Value Measurement," defines fair value as the price that would be received upon sale of an asset or paid upon transfer of a liability in an orderly transaction between market participants at the measurement date and in the principal or most advantageous market for that asset or liability.  The fair value should be calculated based on assumptions that market participants would use in pricing the asset or liability, not on assumptions specific to the entity.

21

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND NINE MONTHS ENDED FEBRUARY 29, 2016 AND FEBRUARY 28, 2015 (UNAUDITED) (IN U.S. $)
 
NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
CASH AND CASH EQUIVALENTS
The Company considers all demand and time deposits and all highly liquid investments with an original maturity of three months or less to be cash equivalents.
FIXED ASSETS
Fixed assets are recorded at cost, less accumulated depreciation.  Cost includes the price paid to acquire the asset, and any expenditures that substantially increase the asset's value or extends the useful life of an existing asset.  Depreciation is computed using the straight-line method over the estimated useful lives of the assets.  Major repairs and betterments that significantly extend the original useful life or improve productivity are capitalized and depreciated over the periods benefited.  Maintenance and repairs are generally expensed as incurred.  The estimated useful lives for fixed asset categories are as follows:
 
Computers and equipment
 3 years
Motor vehicles
 4 years
Furniture and fixtures
 5 years
Investment in leased property
15 years
 
IMPAIRMENT OF LONG-LIVED ASSESTS
The Company applies FASB ASC 360, "Property, Plant and Equipment," which addresses the financial accounting and reporting for the recognition and measurement of impairment losses for long-lived assets.  In accordance with ASC 360, long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable.  The Company may recognize the impairment of long-lived assets in the event the net book value of such assets exceeds the future undiscounted cash flows attributable to those assets.  No impairment of long-lived assets was recognized for the periods presented.
DEFERRED REVENUE
Deferred revenue is advance payments received for patent licensing fees. These payments received, but not yet earned, are recognized as deferred revenue in the consolidated balance sheets.
INCOME TAXES
The Company accounts for income taxes in accordance with FASB ASC 740, "Income Taxes" ("ASC 740"), which requires the recognition of deferred income taxes for differences between the basis of assets and liabilities for financial statement and income tax purposes.  Deferred tax assets and liabilities represent the future tax consequences for those differences, which will either be taxable or deductible when the assets and liabilities are recovered or settled.  As of February 29, 2016, there are no differences between the basis of assets and liabilities for financial statements and income tax purposes and, as a result, there are no deferred income taxes.  A valuation allowance is established when necessary to reduce deferred tax assets to the amount expected to be realized.
22

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND NINE MONTHS ENDED FEBRUARY 29, 2016 AND FEBRUARY 28, 2015 (UNAUDITED) (IN U.S. $)
 
NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
INCOME TAXES (CONTINUED)
ASC 740 addresses the determination of whether tax benefits claimed or expected to be claimed on a tax return should be recorded in the financial statements.  Under ASC 740, the Company may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position.  The tax benefits recognized in the financial statements from such a position would be measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement.  ASC 740 also provides guidance on de-recognition of income tax assets and liabilities, classification of current and deferred income tax assets and liabilities, and accounting for interest and penalties associated with tax positions.  As of February 29, 2016 and May 31, 2015, the Company does not have a liability for any unrecognized tax benefits.
The income tax laws of various jurisdictions in which the Company, its subsidiaries and the VIE operate are summarized as follows:
United States
The Company is subject to United States tax at graduated rates from 15% to 34%.  No provision for income taxes in the United States has been made as the Company had no U.S. taxable income for the three and nine months ended February 29, 2016 and February 28, 2015.
PRC
Jiangsu Xuefeng and Baichuang Consulting are subject to an Enterprise Income Tax at 25% and file their own tax returns.  Consolidated tax returns are not permitted in China.
BVI
Inclusion is incorporated in the BVI and is governed by their income tax laws.  According to current BVI income tax law, the applicable income tax rate for the Company is 0%.
Hong Kong
Lotus is incorporated in Hong Kong.  Pursuant to the income tax laws of Hong Kong, the Company is not subject to tax on non-Hong Kong source income.
ADVERTISING COSTS
Advertising costs are charged to operations when incurred.  For the three months ended February 29, 2016 and February 28, 2015, advertising expense was $250,804 and $12,513, respectively. For the nine months ended February 29, 2016 and February 28, 2015, advertising expense was $639,804 and $36,888, respectively.

23

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND NINE MONTHS ENDED FEBRUARY 29, 2016 AND FEBRUARY 28, 2015 (UNAUDITED) (IN U.S. $)


NOTE 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
STATUTORY RESERVE FUND
Pursuant to corporate law in the PRC, the Company is required to transfer 10% of its net income, as determined under PRC accounting rules and regulations, to a statutory reserve fund until such reserve balance reaches 50% of the Company's registered capital.  The statutory reserve fund is non-distributable other than during liquidation and can be used to fund previous years' losses, if any, and may be utilized for business expansion or used to increase registered capital, provided that the remaining reserve balance after such use is not less than 25% of the registered capital.  For the nine months ended February 29, 2016 and February 28, 2015, a statutory reserve of $433,953 and $236,517, respectively, was required to be allocated by the Company.
NOTE 3.   RECENTLY ISSUED ACCOUNTING STANDARDS
In February 2016, the FASB issued Accounting Standards Update No. 2016-02, Leases. The new standard establishes a right-of-use ("ROU") model that requires a lessee to record a ROU asset and a lease liability on the balance sheet for all leases with terms longer than 12 months. Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition in the income statement. The new standard is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. A modified retrospective transition approach is required for lessees for capital and operating leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements, with certain practical expedients available. This accounting standard update is not expected to have a material impact on the Company's financial statements.
In January 2016, the FASB issued ASU No. 2016-01, Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities. The updated guidance enhances the reporting model for financial instruments, which includes amendments to address aspects of recognition, measurement, presentation and disclosure. The update to the standard is effective for the Company beginning June 1, 2018. The Company is currently evaluating the effect the guidance will have on the Consolidated Financial Statements.
In August 2015, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") 2015-14, Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date. The amendment is effective for all entities for fiscal years and interim periods within those fiscal years, beginning after December 15, 2017. Earlier application is permitted only as of annual reporting periods beginning after December 15, 2016, including interim reporting periods within that reporting period. The Company is evaluating the impact of this standard on its Consolidated Financial Statements.

24

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND NINE MONTHS ENDED FEBRUARY 29, 2016 AND FEBRUARY 28, 2015 (UNAUDITED) (IN U.S. $)
 
NOTE 3.   RECENTLY ISSUED ACCOUNTING STANDARDS (CONTINUED)
In March 2015, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") ASU 2015-03 – Interest – Imputation of Interest (Subtopic 835-30). This ASU addressed the simplification of debt issuance costs presentation by presenting debt issuance costs in the balance sheet as a direct deduction from the carrying amount of debt liability, consistent with debt discounts or premiums. For public business entities, the amendments in this Update are effective for financial statements issued for fiscal years beginning after December 15, 2015, and interim periods within those fiscal years. This accounting standard update is not expected to have a material impact on the Company's consolidated financial statements.
In January 2015, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") ASU 2015-01 – Income Statement – Extraordinary and Unusual Items (Subtopic 225-20).  This ASU addressed the simplification of income statement presentation by eliminating the concept of extraordinary items.  The objective of the Simplification Initiative is to identify, evaluate, and improve areas of generally accepted accounting principles (GAAP) for which cost and complexity can be reduced while maintaining or improving the usefulness of the information provided to the users of financial statements.  The amendments in this update are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. A reporting entity may apply the amendments prospectively.  A reporting entity also may apply the amendments retrospectively to all prior periods presented in the financial statements.  Early adoption is permitted provided that the guidance is applied from the beginning of the fiscal year of adoption.  This accounting standard update will not have a material impact on the Company's consolidated financial statements.
In August 2014, the FASB issued authoritative guidance that requires an entity's management to evaluate whether there are conditions or events, considered in the aggregate, that raise substantial doubt about the entity's ability to continue as a going concern and requires additional disclosures if certain criteria are met. This guidance is effective for fiscal periods ending after December 15, 2016, with early adoption permitted. This accounting standard update is not expected to have any impact on the Company's financial statements.
NOTE 4.   FAIR VALUE MEASUREMENTS
FASB ASC 820, "Fair Value Measurement," specifies a hierarchy of valuation techniques based upon whether the inputs to those valuation techniques reflect assumptions other market participants would use based upon market data obtained from independent sources (observable inputs).  In accordance with ASC 820, the following summarizes the fair value hierarchy:
Level 1 Inputs – Unadjusted quoted market prices for identical assets and liabilities in an active market that the Company has the ability to access.
Level 2 Inputs – Inputs other than the quoted prices in active markets that are observable either directly or indirectly.
Level 3 Inputs – Inputs based on prices or valuation techniques that are both unobservable and significant to the overall fair value measurements.
25

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND NINE MONTHS ENDED FEBRUARY 29, 2016 AND FEBRUARY 28, 2015 (UNAUDITED) (IN U.S. $)
 
NOTE 4.   FAIR VALUE MEASUREMENTS (CONTINUED)
ASC 820 requires the use of observable market data, when available, in making fair value measurements.  When inputs used to measure fair value fall within different levels of the hierarchy, the level within which the fair value measurement is categorized is based on the lowest level input that is significant to the fair value measurement.  Valuation techniques used need to maximize the use of observable inputs and minimize the use of unobservable inputs.  As of February 29, 2016 and May 31, 2015, none of the Company's assets and liabilities were required to be reported at fair value on a recurring basis. Carrying values of non-derivative financial instruments, including cash, accounts receivable, prepaid expenses, accounts payable, deferred revenues, taxes payable and accrued liabilities, approximate their fair values due to the short term nature of these financial instruments.  There were no changes in methods or assumptions during the periods presented.
NOTE 5.   FIXED ASSETS
Fixed assets are summarized as follows:
   
February 29,
2016
   
May 31,
2015
 
   
(Unaudited)
     
         
Computers and equipment
 
$
52,586
   
$
31,971
 
Vehicles
   
88,393
     
15,302
 
Investment in leased property
   
12,958,475
     
-
 
Furniture and fixtures
   
12,348
     
13,213
 
                 
     
13,111,802
     
60,486
 
Less: accumulated depreciation
   
(257,013
)
   
(44,368
)
                 
   
$
12,854,789
   
$
16,118
 
For the three and nine months ended February 29, 2016 and February 28, 2015, depreciation expense was $181,884 and $2,454, respectively, $222,049 and $9,162, respectively.
NOTE 6.   INCOME TAXES

   
For The Three Months Ended
 
   
February 29,
2016
   
February 28,
2015
 
   
(Unaudited)
   
(Unaudited)
 
         
Current
 
$
371,708
   
$
437,287
 
Deferred
   
-
     
-
 
                 
   
$
371,708
   
$
437,287
 

26

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND NINE MONTHS ENDED FEBRUARY 29, 2016 AND FEBRUARY 28, 2015 (UNAUDITED) (IN U.S. $)
 
NOTE 6.   INCOME TAXES (CONTINUED)

   
For The Nine Months Ended
 
   
February 29,
2016
   
February 28,
2015
 
   
(Unaudited)
   
(Unaudited)
 
         
Current
 
$
1,446,510
   
$
788,384
 
Deferred
   
-
     
-
 
                 
   
$
1,446,510
   
$
788,384
 
 
The expected tax rate for income in the PRC is 25% which is approximately the same as the effective tax rate for the periods presented.
The Company is required to file income tax returns in both the PRC and the United States.  PRC tax filings for the tax year ended December 31, 2014 and 2013 were examined by the PRC tax authorities in May 2015 and 2014, respectively. The tax filings were accepted and no adjustments were proposed by the PRC tax authorities.
The Company did not file its U.S. federal income tax returns, including, without limitation, information returns on Internal Revenue Service ("IRS") Form 5471, "Information Return of U.S. Persons with Respect to Certain Foreign Corporations" for the fiscal years ended May 31, 2015, May 31, 2014, April 30, 2013 and for the one month period ended May 31, 2013, a short year income tax return required to be filed as a result of the change in fiscal year.  Failure to furnish any income tax returns and information returns with respect to any foreign business entity required, within the time prescribed by the IRS, subjects the Company to certain civil penalties.  Management is of the opinion that penalties, if any, that may be assessed would not be material to the consolidated financial statements.
In addition, because the Company did not generate any income in the United States or otherwise have any U.S. taxable income, the Company does not believe that it has any U.S. Federal income tax liabilities with respect to any transactions that the Company or any of its subsidiaries may have engaged in through May 31, 2015. However, there can be no assurance that the IRS will agree with this position, and therefore the Company ultimately could be liable for U.S. Federal income taxes, interest and penalties. The tax years ended May 31, 2015, 2014 and 2013 remain open to examination by the IRS.
NOTE 7.   RELATED PARTY TRANSACTIONS
On August 5, 2012, the Company entered into an agreement to lease the patent rights on garbage recycling processing technology from Li Yuan, one of the Company's stockholders.  Under the current terms, the Company is required to pay a fee of $12,576 (RMB 80,000) each month for five years from September 2012 to August 2017.  The related prepaid patent leasing fees of $122,090 and $91,448 are included in prepaid expenses on the consolidated balance sheets as of February 29, 2016 and May 31, 2015 respectively.

27

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND NINE MONTHS ENDED FEBRUARY 29, 2016 AND FEBRUARY 28, 2015 (UNAUDITED) (IN U.S. $)
 
NOTE 7.   RELATED PARTY TRANSACTIONS (CONTINUED)
The remaining payments for the patent rights are as follows:

Year Ending
   
May 31,
 
Amount
 
     
2017
 
$
61,040
 
2018
   
36,624
 
         
   
$
97,664
 

The Company obtained a demand loan from Li Yuan, a stockholder which is non-interest bearing.  The total loan of approximately $450,000 represents $371,000 of expenses paid by the stockholder and payments of approximately $79,000 representing the registered capital and operating expenses of Baichuang Information Consulting (Shenzhen) Co., Ltd. The balance is reflected as loan from stockholder as of February 29, 2016 and May 31, 2015.
NOTE 8.   LEASES
The Company leases office space under a one-year operating lease from an unrelated third party, which expires on March 31, 2016.  The lease requires the Company to prepay the rental for one year of $7,021 (RMB 44,664).  The related prepayments of $585 and $6,078 are included in prepaid expenses on the consolidated balance sheets as of February 29, 2016 and May 31, 2015, respectively.  The lease provides for renewal options.  Rent expense for the three and nine months ended February 29, 2016 and February 28, 2015 was $1,712 and $1,814 respectively, $5,266 and $5,443, respectively.
The Company entered into a new lease agreement with an unrelated third party for new office space, which commenced on April 1, 2016 and expires on March 31, 2019.  The lease requires the Company to prepay the semi-annual rental of $3,773 (RMB 24,000). The lease provides for renewal options.
Future minimum payments for the years ending May 31 are as follows:
Year Ending
   
May 31,
 
Amount
 
     
2016
 
$
1,258
 
2017
   
7,546
 
2018
   
7,546
 
2019
   
6,288
 
         
   
$
22,638
 

28

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND NINE MONTHS ENDED FEBRUARY 29, 2016 AND FEBRUARY 28, 2015 (UNAUDITED) (IN U.S. $)


NOTE 9.   CONTINGENCIES AND COMMITMENTS
As disclosed in Note 6, the Company is delinquent in filing certain tax returns with the U.S. Internal Revenue Service.  The Company is unable to determine the amount of penalties, if any, that may be assessed at this time.  Management is of the opinion that penalties, if any, that may be assessed would not be material to the consolidated financial statements.
The Company did not file the information reports for the years ended December 31, 2014, 2013 and 2012 concerning its interest in foreign bank accounts on form TDF 90-22.1, "Report of Foreign Bank and Financial Accounts" ("FBAR"). Not complying with the FBAR reporting and recordkeeping requirements will subject the Company to civil penalties up to $10,000 for each year it has foreign bank accounts.  The Company has not determined the amount of any penalties that may be assessed at this time and believes that penalties, if any, that may be assessed would not be material to the consolidated financial statements.
In February 2016, the Company entered into an agreement to have manufactured a 500 ton highly efficient organic waste disposal piece of equipment for $5,344,800 (RMB 34,000,000). Under the agreement, the Company was required to pay 60% within 30 days upon the signing of the agreement, 35% within one month after the delivery of the equipment, and the remaining 5% as retainage to be paid within the six months. The Company made the initial payment of $3,206,880 (RMB 20,400,000) on March 31, 2016.
NOTE 10.   VULNERABILITY DUE TO OPERATIONS IN THE PRC
The Company's operations may be adversely affected by significant political, economic and social uncertainties in the PRC. The different cultures, business preferences, corruption, diverse uncertain government regulations, tax systems and currency regulations are risks impacting the Company's current operations. Although the PRC government has been pursuing economic reform policies for more than twenty years, no assurance can be given that the PRC government will continue to pursue such policies or that such policies may not be significantly altered, especially in the event of a change in leadership, social or political disruption or unforeseen circumstances affecting the PRC's political, economic and social conditions.  There is also no guarantee that the PRC government's pursuit of economic reforms will be consistent, effective or continue.
NOTE 11.   CONCENTRATION OF CREDIT AND BUSINESS RISK
Cash and cash equivalents
Substantially all of the Company's bank accounts are in banks located in the PRC and are not covered by protection similar to that provided by the FDIC on funds held in United States banks.
 
29

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND NINE MONTHS ENDED FEBRUARY 29, 2016 AND FEBRUARY 28, 2015 (UNAUDITED) (IN U.S. $)
 
NOTE 11.   CONCENTRATION OF CREDIT AND BUSINESS RISK (CONTINUED)
Major customers
For the three months ended February 29, 2016 and February 28, 2015, the Company had three different customers that accounted for 53% and 66% of revenue, respectively. For the nine months ended February 29, 2016 and February 28, 2015, the Company had two different customers and three different customers that accounted for 76% and 48% of revenue, respectively. These two customers account for 100% accounts receivable at February 29, 2016.
NOTE 12.   CONDENSED FINANCIAL INFORMATION OF THE PARENT COMPANY
The condensed financial information of the Company's US parent only balance sheet as of May 31, 2015, and the related statements of income and cash flows for the year ended May 31, 2015 are as follows:
Condensed Balance Sheets
ASSETS
 
May 31,
2015
 
     
  Investment in subsidiaries and VIE
 
$
22,818,109
 
         
TOTAL ASSETS
 
$
22,818,109
 

30

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND NINE MONTHS ENDED FEBRUARY 29, 2016 AND FEBRUARY 28, 2015 (UNAUDITED) (IN U.S. $)
 

NOTE 12.   CONDENSED FINANCIAL INFORMATION OF THE PARENT COMPANY (CONTINUED)
Condensed Balance Sheets (Continued)
LIABILITIES AND STOCKHOLDERS' EQUITY
 
May 31,
2015
 
     
Current liabilities:
   
     
  Loan from stockholder
 
$
376,678
 
  Accrued liabilities
   
36,000
 
         
Total current liabilities
   
412,678
 
         
Stockholders' equity:
       
Common stock, $0.001 par value; 75,000,000 shares authorized; 55,200,000 shares issued and outstanding
   
55,200
 
 Additional paid-in capital
   
11,389,049
 
 Retained earnings
   
10,961,182
 
         
Total stockholders' equity
   
22,405,431
 
         
TOTAL LIABILITIES AND STOCKHOLDERS'  EQUITY
 
$
22,818,109
 
Condensed Statements of Income
   
For The Year
Ended
May 31,
 
   
2015
 
     
Revenues:
   
 Share of earnings from investment in subsidiaries and VIE
 
$
4,497,498
 
         
Operating expenses:
       
 General and administrative
   
115,000
 
         
Net income
 
$
4,382,498
 

31


CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND NINE MONTHS ENDED FEBRUARY 29, 2016 AND FEBRUARY 28, 2015 (UNAUDITED) (IN U.S. $)
 
NOTE 12.   CONDENSED FINANCIAL INFORMATION OF THE PARENT COMPANY (CONTINUED)
Condensed Statements of Cash Flows
   
For The Year
 Ended
May 31,
 
   
2015
 
     
Cash flows from operating activities:
   
 Net income
 
$
4,382,498
 
 Adjustments to reconcile net income to net cash provided by (used in) operating activities
       
 Share of earnings from investment in subsidiaries and VIE
   
(4,497,498
)
     Increase in accrued liabilities
   
115,000
 
         
    Net cash (used in) provided by operating activities
   
-
 
         
Net increase in cash
   
-
 
Cash, beginning of year
   
-
 
         
Cash, end of year
 
$
-
 
         
Noncash financing activities:
       
      Payment of accrued liabilities by shareholder
 
$
147,683
 
 
Basis of Presentation
The Company records its investment in its subsidiaries and VIE under the equity method of accounting.  Such investment is presented as "Investment in subsidiaries and VIE" in the condensed balance sheet and the U.S. parent's share of the subsidiaries and VIE's profits are presented as "Share of earnings from investment in subsidiaries and VIE" in the condensed statements of income and cash flows.
Certain information and footnote disclosures normally included in financial statements prepared in conformity with accounting principles generally accepted in the United States of America have been condensed or omitted.  The parent only financial information has been derived from the Company's consolidated financial statements and should be read in conjunction with the Company's consolidated financial statements.

32

CHINA XUEFENG ENVIRONMENTAL ENGINEERING INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND NINE MONTHS ENDED FEBRUARY 29, 2016 AND FEBRUARY 28, 2015 (UNAUDITED) (IN U.S. $)
 
NOTE 12.   CONDENSED FINANCIAL INFORMATION OF THE PARENT COMPANY (CONTINUED)
Restricted Net Assets
Under PRC laws and regulations, the Company's PRC subsidiary and VIE are restricted in their ability to transfer certain of their net assets to the parent company in the form of dividend payments, loans or advances.  The restricted net assets of the Company's PRC subsidiary and VIE amounted to $25,239,451 and $22,818,109 as of February 29, 2016 and May 31, 2015, respectively.
In addition, the Company's operations and revenues are conducted and generated in the PRC; all of the Company's revenues being earned and currency received are denominated in RMB. RMB is subject to the foreign exchange control regulations in China, and, as a result, the Company may be unable to distribute any dividends outside of China due to PRC's foreign exchange control regulations that restrict the Company's ability to convert RMB into US Dollars.
Schedule I of Article 5-04 of Regulation S-X requires the condensed financial information of the parent company to be filed when the restricted net assets of consolidated subsidiaries and VIE's exceed 25 percent of consolidated net assets as of the end of the most recently completed fiscal year.  For purposes of this test, restricted net assets of consolidated subsidiaries and VIEs shall mean that amount of the registrant's proportionate share of net assets of its consolidated subsidiaries and VIEs (after intercompany eliminations) which as of the end of the most recent fiscal year may not be transferred to the parent company in the form of loans, advances or cash dividends without the consent of a third party.  The condensed parent company financial statements have been prepared in accordance with Rule 12-04, Schedule I of Regulation S-X as the restricted net assets of the Company's PRC subsidiary and VIE exceed 25% of the consolidated net assets of the Company.

33

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.
The following discussion of our financial condition and results of operations should also be read in conjunction with our unaudited consolidated financial statements and the notes to those financial statements appearing elsewhere in this Form 10-Q. The following discussion contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 relating to future events or our future performance. Actual results may materially differ from those projected in the forward-looking statements as a result of certain risks and uncertainties set forth in this Form 10-Q. Although management believes that the assumptions made and expectations reflected in the forward-looking statements are reasonable, there is no assurance that the underlying assumptions will, in fact, prove to be correct or that actual results will not be different from expectations expressed in this report.

Overview
 
We are in the business of providing equipment and upgrade services to optimize garbage-recycling processes. We sell and lease comprehensive and harmless garbage recycling equipment. We also utilize our licensed patented technology of "comprehensive and harmless garbage-processing equipment" to upgrade software systems and reconstruct hardware for our clients and therefore expand the sorting scope and capacity of our clients' garbage recycling equipment. We also have manufactured and sell or lease garbage-processing equipment commencing during the three months ended February 29, 2016. We conduct our operations through our controlled consolidated affiliate Jiangsu Xuefeng Environmental Protection Science and Technology Co., Ltd. ("Jiangsu Xuefeng")
 
Our Services
 
With the development of the urbanization in China, the amount of household garbage is growing, whereas the processing capability of garbage processing equipment cannot satisfy the increasing amount of garbage. In order to improve the processing equipment of garbage processing plants, we provide upgrades and improvements to the software systems and hardware equipment by installing various systems of our licensed patented technology "comprehensive and harmless garbage-processing equipment" into customers' equipment, and reconstruct the hardware to expand the garbage sorting scope and capacity of their equipment.

The comprehensive and harmless garbage processing equipment that we sell or lease is comprised of a waste digestion pretreatment system, methane gas power generation system, sorting processing system, bricklaying building system, leachate treatment system, DCS (distribution control system), XFET-5 ecological and water-saving toilets and excrement comprehensive processing system and various material collection systems. The equipment technology is designed and manufactured based on the complicated situation of the household garbage in China. According to the features of various garbage, the equipment utilizes the wind-force, gravity, magnetic, shape, etc. to process the garbage by the combined way of machine selecting, winnowing, magnetic separation, automatic cutting, smashing and other technological processes. The equipment has large processing capacity and can run all day. The stand-alone equipment can process 500 to 1000 tons of garbage per day. It can sort and process complicated municipal solid waste, leaving almost no pollution and no residue, reaching the "3 without" standard of no waste gas, no waste water and no waste residue.

The licensed Patented technology of "harmless and comprehensive garbage processing equipment" provided by Jiangsu Xuefeng to its customers has a high garbage processing capacity and stable operation capacity. It is the first modern system equipment in China to use DCS (Distributed Control System) centralized control, by which mechanical automation will be realized for the comprehensive treatment of life garbage. Its core technology is to organically integrate the anaerobic digestion and aerobic fermentation garbage process, degrade and transform the organic matter of domestic waste, effectively sort out the garbage and recycle all kinds of materials, to eventually realize the true waste resource utilization and harmless utilization rate, approaching 100%. The resource recovery products, biogas, can not only be used for meeting the needs of the plant itself, but also for sale outside the company, which greatly improves the efficiency of the garbage processing equipment, decreases production costs, and increases the recovery return of garbage processing.

After we sell or lease the equipment or complete the internal system upgrade and hardware equipment improvements of the clients' garbage equipment, we deliver the upgraded equipment to the customers. The customers will conduct an inspection and performance testing of the upgraded equipment within one month pursuant to the contract to inspect whether the internal control system and the hardware structure can operate steadily and achieve the expected results. The inspection includes the following: whether the quality of the equipment and accessories or after improvement can match the licensed patented technology and process various kinds of garbage, whether the various garbage systems can process automatically, and whether the daily garbage processing capacity reaches the expected results per the contract. If during the performance testing period, the performance meets the requirements of the contract, it would be deemed that we have fully fulfilled our obligations under the contract.
 
When we complete the upgrading service for a client, we go through the acceptance check and commissioning of the company in accordance with the contract, to make sure that the services provided met the expectations of the clients. After that, we are not subject to any additional services. The revenue we generated belongs to the service class income, with the main cost being the salaries of the staff and the leasing fees for the patent, whereas the hardware and software equipment, as well as the material used in the upgrading process are the responsibility of the client.

34

We are an "emerging growth company", or "EGC" as defined in the Jumpstart Our Business Startups Act, or the JOBS Act, and we are eligible to take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not "emerging growth companies" including, but not limited to, reduced disclosure obligations regarding executive compensation in our periodic reports and proxy statements, exemptions from the requirements of holding a nonbinding advisory vote on executive compensation, and stockholder approval of any golden parachute payments not previously approved in connection with a transaction resulting in a change of control. We expect to take advantage of these exemptions, when applicable. By taking advantage of these exemptions, we do not know if some investors will find our common stock less attractive as a result. The result may be a less active trading market for our common stock and the stock price may be more volatile.

While we have not yet done so, Section 107 of the JOBS Act also provides that an "emerging growth company" can take advantage of the extended transition period provided in Section 7(a)(2)(B) of the Securities Act of 1933, as amended, for complying with new or revised accounting standards. In other words, an "emerging growth company" can delay the adoption of certain accounting standards until those standards would otherwise apply to private companies.

We could remain an "emerging growth company" for up to five years, or until the earliest of (i) the last day of the first fiscal year in which our annual gross revenues exceed $1 billion, (ii) the date that we become a "large accelerated filer" as defined in Rule 12b-2 under the Securities Exchange Act of 1934, as amended, which would occur if the market value of our common stock that is held by non-affiliates exceeds $700 million as of the last business day of our most recently completed second fiscal quarter, or (iii) the date on which we have issued more than $1 billion in non-convertible debt during the preceding three year period.

Results of Operations

Three Months Ended February 29, 2016 compared to the Three Months Ended February 28, 2015

The following table sets forth in U.S. dollars, key components of our unaudited results of operations for the three months ended February 29, 2016 and February 28, 2015, and the percentage change between 2016 and 2015.

 
 
Three Months Ended,
 
 
 
February 29,
2016
   
February 28,
2015
   
Percentage
 
 
 
(U.S. $)
   
(U.S. $)
   
Change
 
 
 
   
   
 
Revenue
 
$
2,149,607
   
$
1,950,000
     
10
%
Cost of revenue
   
(312,860
)
   
(95,119
)
   
229
%
      Gross profit
   
1,836,747
     
1,854,881
     
(1
%)
    Selling expenses
   
344,441
     
25,795
     
1,235
%
    General and administrative expenses
   
191,527
     
98,755
     
94
%
      Total operating expenses
   
535,968
     
124,550
     
330
%
Operating income
   
1,300,779
     
1,730,331
     
(25
%)
    Interest income
   
161,052
     
18,816
     
756
%
Income before provision for income taxes
   
1,461,831
     
1,749,147
     
(16
%)
Provision for income taxes
   
371,708
     
437,287
     
(15
%)
Net income
   
1,090,123
     
1,311,860
     
(17
%)
    Noncontrolling interests
   
(54,171
)
   
(63,916
)
   
(15
%)
Net income attributable to common  stockholders
 
$
1,035,952
   
$
1,247,944
     
(17
%)

Revenue
 
We provide improvement and upgrading services for garbage processing equipment to our customers. This is a one-time service. We also license patent to our customers. The patent licensing is limited to five years with payments due annually in advance. For the three months ended February 29 2016 and February 28, 2015, we didn't produce and sell garbage processing equipment.

35

Our revenue for the three months ended February 29, 2016 increased by $199,607 or 10% compared to the revenue for the three months ended February 28, 2015. The following table sets forth our revenue for the three months ended February 29, 2016 and February 28, 2015:
 
 
Three Months Ended,
 
 
February 29,
2016
 
February 28,
2015
 
Percentage
 
 
(U.S. $)
 
(U.S. $)
 
Change
 
       
Improvements and Upgrading Services
 
$
797,160
   
$
1,072,500
 
(26
%)
Patent Leasing
 1,011,780
 
  877,500
 
 15
%
Sales type lease
  -
 
   -
 
 -
%
Operating leases
   
340,667
     
-
     
100
%
Total
 
$
2,149,607
   
$
1,950,000
     
10
%

Improvement and Upgrading Services
 
For the three months ended February 29, 2016, we provided improvement and upgrading services to one customer and generated revenue of $797,160. For the three months ended February 28, 2015, we provided such services to three customers. We will still focus on providing improvement and upgrading services for customers' garbage processing equipment although we are currently having manufactured and selling or leasing garbage processing equipment.

Patent Licensing

For the three months ended February 29, 2016, revenue from patent licensing was from 15 unrelated customers totaling $1,011,780. As 14 customers were licensed in the prior year and one commenced on October 1, 2015, the patent licensing revenue was recognized for the whole three months for these 14 customers except one customer terminated the agreement with us on February 1, 2016. For the three months ended February 28, 2015, revenue from patent licensing was from 12 unrelated customers totaling $877,500 of which all the customers were signed before December 1, 2013.

Operating lease
 
During the three months ended February 29, 2016, we had three operating leases for a 300-ton and two 500-ton garbage processing system. The lease period is 5 years with annual lease payments of $628,800 and $1,509,120 (for the two 500-ton garbage processing system), respectively, before VAT. The 300-ton garbage processing system was delivered and tested in the beginning of November 2015. The two 500-ton garbage processing systems were delivered and tested in the beginning of January 2016. These leases are being accounted for as an operating lease because they have no renewal or purchase option. At the end of the five years, either a new lease will be negotiated or the equipment will be returned. For the three months ended February 28, 2015, we didn't have any operating lease revenue.

Cost of Revenues 
 
Our cost of revenues increased to $312,860 for the three months ended February 29, 2016 from $95,119 for the three month ended February 28, 2015, which represented an increase of 229%. Our costs of revenue relating to improvement and upgrading service and patent licensing revenue primarily consists of fees paid to the related party for licensing the patent, employees' salaries and training expenses. For the operating lease revenue, the depreciation of the garbage processing equipment is also included in the cost of revenue. The main reason for the increase in our cost of revenue was due to the increased number of technical personnel.
 
Gross Profit
 
Our gross profit decreased to $1,836,747 for the three months ended February 29, 2016 from $1,854,881 for the three months ended February 28, 2015, which represented a decrease of 1%. Our gross profit ratio was reduced significantly due to the increase in our cost of revenue. The gross profit ratio for three months ended February 29, 2016 and February 28, 2015 is 85% and 95%, respectively.
 
36

Selling and Marketing Expenses 
 
Our selling and marketing expenses increased to $344,441 for the three months ended February 29, 2016 from $25,795 for the three months ended February 28, 2015, which represented an increase of 1,235%. Our selling and marketing expenses were primarily comprised of sales employees' salaries, advertising expenses, training expenses and travelling expenses. This increase was mainly due to the increase in advertising expenses. Our advertising expenses increased to $250,804 for the three months ended February 29, 2016 from $12,513 for the three months ended February 28, 2015. In addition, employees' salaries increased as well.
 
General and Administrative Expenses
 
Our general and administrative expenses increased to $191,527 for the three ended February 29, 2016 from $98,755 for the three month ended February 28, 2015, representing an 94% increase. Our general and administrative expenses were primarily comprised of employees' salaries, travelling expenses, entertainment expenses and professional fees such as legal and audit fees. The increase is primarily due to the significant increase of employees' salaries, travelling expenses and entertainment expenses.
 
Interest income

Despite our large cash balances, the interest income generated for the three months ended February 29, 2016 was nominal for principally two reasons: the bank's current deposit interest rate is very low, and the annual interest rates float up or down within a 0.30% range; The interest income reported in our financial statements is net after deducting bank service charges. For the three months ended February 29, 2016, our interest income also includes interest earned of $153,863 charged on the balance outstanding for the sales type leases for the garbage processing equipment.

Provision for Income Taxes  
 
Our provision for income taxes decreased to $371,708 for the three months ended February 29, 2016 from $437,287 for the three months ended February 28, 2015. Our effective tax rate for the three months ended February 29, 2016 and February 28, 2015 was approximately the statutory rate of 25%. Our tax filings for the calendar year ended December 31, 2014 were examined by the PRC tax authorities in May 2015. Our prior filings were accepted and no adjustments were proposed. The decrease in the provision for income taxes was primarily due to the decrease in our pre-tax income.
 
Net Income
 
For the three months ended February 29, 2016 and February 28, 2015, we generated net income of $1,090,123 and $1,311,860, respectively.  This represented a decrease of $221,737 or 17% from the three months ended February 28, 2015. The entrusted management agreements assign to Baichuang Consulting 95% of the income generated from Jiangsu Xuefeng.  For that reason, we reflected a "non-controlling interest" of $54,171 and $63,916 for the three months ended February 29, 2016 and February 28, 2015, respectively, before recognizing net income attributable to the common stockholders of the Company.  After the "non-controlling interest", our net income attributable to the common stockholders' of the Company for the three months ended February 29, 2016 and February 28, 2015 was $1,035,952 and $1,247,944, representing $0.02 and $0.02 per share, respectively.
 
Foreign Currency Translation Adjustment 
 
Our reporting currency is the U.S. dollar. Our local currency, Renminbi (RMB), is our functional currency. Results of operations and cash flows are translated at average exchange rates during the period, and assets and liabilities are translated at the unified exchange rate as quoted by the People's Bank of China at the end of the period. Equity transactions are recorded at their historical amounts. Translation adjustments resulting from this process are included in accumulated other comprehensive income in the statement of stockholders' equity. Transaction gains and losses that arise from exchange rate fluctuations on transactions denominated in a currency other than the functional currency are included in the results of operations as incurred. For the three months ended February 29, 2016 and February 28, 2015, a foreign currency gain (loss) of $(553,887) and $(99,691), respectively, have been reported as other comprehensive income in the consolidated statements of income and other comprehensive income. The foreign currency loss was mainly due to the devaluation of the Chinese currency by approximately 3.5%.

37

Nine Months Ended February 29, 2016 compared to Nine Months Ended February 28, 2015

The following table sets forth in U.S. dollars, key components of our unaudited results of operations for the nine months ended February 29, 2016 and February 28, 2015, and the percentage change between 2016 and 2015.

 
 
Nine Months Ended,
 
 
 
February 29,
2016
   
February 28,
2015
   
Percentage
 
 
 
(U.S. $)
   
(U.S. $)
   
Change
 
 
 
   
   
 
Revenue
 
$
19,130,031
   
$
3,705,000
     
416
%
Cost of revenue
   
(12,250,760
)
   
(249,936
)
   
4,802
%
      Gross profit
   
6,879,271
     
3,455,064
     
99
%
    Selling expenses
   
907,819
     
76,407
     
1,088
%
    General and administrative expenses
   
525,970
     
280,432
     
88
%
      Total operating expenses
   
1,433,789
     
356,839
     
302
%
Operating income
   
5,445,482
     
3,098,225
     
76
%
    Interest income
   
267,558
     
55,284
     
384
%
Income before provision for income taxes
   
5,713,040
     
3,153,509
     
81
%
Provision for income taxes
   
1,446,510
     
788,384
     
83
%
Net income
   
4,266,530
     
2,365,125
     
80
%
Noncontrolling interests
   
(212,096
)
   
(113,229
)
   
87
%
Net income attributable to common  stockholders
 
$
4,054,434
   
$
2,251,896
     
80
%

Revenue
 
We provide improvement and upgrading services for garbage processing equipment to our customers. This is a one-time service. We also license a patent to our customers. The patent licensing is limited to five years with payments due annually in advance. During the nine months ended February 29, 2016, we began having manufactured and sell or lease the garbage processing equipment to our customers.

Our revenue for the nine months ended February 29, 2016 increased by $15,425,031 or 416% compared to the revenue for the nine months ended February 28, 2015. The primary reason for the significant increase in revenue was mainly due to the increase in the sale of equipment and improvement and upgrade services for garbage processing equipment. The following table sets forth our revenue for the nine months ended February 29, 2016 and February 28, 2015:

 
Nine Months Ended,
 
 
February 29,
2016
 
February 28,
2015
 
Percentage
 
 
(U.S. $)
 
(U.S. $)
 
Change
 
       
Improvements and Upgrading Services
 
$
1,289,040
   
$
1,072,500
 
 20
%
Patent Leasing
  3,065,400
 
  2,632,500
 
 16
%
Sales type lease
  14,381,471
 
   -
 
 100
%
Operating lease
   
394,120
     
-
     
100
%
 Total
 
$
19,130,031
   
$
3,705,000
     
416
%

Improvement and Upgrading Services
 
For the nine months ended February 29, 2016, we provided improvement and upgrading services to two customers and generated revenue of $1,289,040. For the nine months ended February 28, 2015, we provided such services to three customers and generated revenue of $1,072,500. We will still focus on providing improvement and upgrading services for customers' garbage processing equipment although we are currently having manufactured and selling or leasing the garbage processing equipment.
 
Patent Licensing
 
For the nine months ended February 29, 2016, revenue from patent licensing was from 15 unrelated customers totaling $3,065,400. As 14 customers were licensed in the prior year and one commenced in October 1, 2015, patent licensing revenue was recognized for the entire nine months for these 14 customers. For the nine months ended February 28, 2015, revenue from patent licensing was from 12 unrelated customers totaling $2,632,500 of which all the customers were signed before December 1, 2013.

38

Sales Type Lease
 
During the nine months ended February 29, 2016, we leased equipment for garbage processing to two customers. These sales were recognized as sales type leases because title to the equipment will be transferred to the customers at the end of the lease. The equipment was sold for $14,381,471 before VAT. We received 33.9% and 27.5% of the selling price from the two customers during the nine months ended February 29, 2016, respectively. We will receive quarterly payments of $1,194,720 during the following three years including interest at 5.25%. For the nine months ended February 28, 2015, we didn't have any sales type lease revenue.

Operating lease
 
During the nine months ended February 29, 2016, we had three operating leases for a 300-ton and two 500-ton garbage processing system. The lease period is 5 years with annual lease payments of $628,800 and $1,509,120 (for the two 500-ton garbage processing system), respectively, before VAT. The 300-ton garbage processing system was delivered and tested in the beginning of November 2015. The two 500-ton garbage processing systems were delivered and tested in the beginning of January 2016. These leases are being accounted for as operating leases because they have no renewal or purchase option. At the end of the five years, either a new lease will be negotiated or the equipment will be returned. For the nine months ended February 28, 2015, we didn't have any operating lease revenue.

Cost of Revenues 
 
Our cost of revenues increased to $12,250,760 for the nine months ended February 29, 2016 from $249,936 for the nine months ended February 28, 2015, which represented an increase of 4,802%. This is mainly attributable to the $11,604,089 cost of the garbage processing equipment sold under the sales type lease. For improvement and upgrading service and patent licensing revenue, the cost primarily consists of fees paid to the related party for licensing the patent, employees' salaries and training expenses. In addition, the cost of the garbage processing equipment also includes various equipment and supplies necessary for assembling and installing equipment and the related labor. For the operating lease revenue, the depreciation of the garbage processing equipment is also included in the cost of revenue.
 
Gross Profit
 
Our gross profit increased to $6,879,271 for the nine months ended February 29, 2016 from $3,455,064 for the nine months ended February 28, 2015. However, our gross profit ratio was reduced significantly due to the cost of garbage processing equipment we sold under the sales type leases. The gross profit ratio for the nine months ended February 29, 2016 and February 28, 2015 is 36% and 93%, respectively.
 
Selling and Marketing Expenses 
 
Our selling and marketing expenses increased to $907,819 for the nine months ended February 29, 2016 from $76,407 for the nine months ended February 28, 2015 which represented an increase of 1,088%. Our selling and marketing expenses were primarily comprised of sales employees' salaries, advertising expenses, training expenses and travelling expenses. The increase was mainly due to the significant increase in advertising expenses. Our advertising expenses increased to $639,804 for the nine months ended February 29, 2016 from $36,888 for the nine months ended February 28, 2015. In addition, employees' salaries increased as well.

General and Administrative Expenses
 
Our general and administrative expenses increased to $525,970 for the nine months ended February 29, 2016 from $280,432 for the nine months ended February 28, 2015, representing an 88% increase. Our general and administrative expenses were primarily comprised of employees' salaries, travelling expenses, entertainment expenses and professional fees such as legal and audit fees. The increase is primarily due to a significant increase of employees' salaries, travelling expenses and entertainment expenses.

Interest income
 
Despite our large cash balances, the interest income generated for the nine months ended February 29, 2016 was nominal for principally two reasons: the bank's current deposit interest rate is very low, and the annual interest rates float up or down within a 0.30% range; The interest income reported is net after deducting bank service charges. For the nine months ended February 29, 2016, our interest income also includes interest of $222,241 earned on the sales type leases.

Provision for Income Taxes
 
Our provision for income taxes increased to $1,446,510 for the nine months ended February 29, 2016 from $788,384 for the nine months ended February 28, 2015. Our effective tax rate for the nine months ended February 29, 2016 and February 28, 2015 was approximately the statutory rate of 25%. Our tax filings for the calendar year ended December 31, 2014 were examined by the PRC tax authorities in May 2015. Our prior filings were accepted and no adjustments were proposed. The increase in the provision for income taxes was primarily due to the increase in our pre-tax income.
 
39

Net Income
 
For the nine months ended February 29, 2016 and February 28, 2015, we generated net income of $4,266,530 and $2,365,125, respectively.  This represented an increase in net income of $1,901,405 or 80% from the nine months ended February 28, 2015. The entrusted management agreements assign to Baichuang Consulting 95% of the income generated from Jiangsu Xuefeng.  For that reason, we reflected a "non-controlling interest" of $212,096 and $113,229 for the nine months ended February 29, 2016 and February 28, 2015, respectively, before recognizing net income attributable to the common stockholders of the Company.  After the "non-controlling interest", our net income attributable to the common stockholders' of the Company for the nine months ended February 29, 2016 and February 28, 2015 was $4,054,434 and $2,251,896, representing $0.07 and $0.04 per share, respectively.
 
Foreign Currency Translation Adjustment

Our reporting currency is the U.S. dollar. Our local currency, Renminbi (RMB), is our functional currency. Results of operations and cash flows are translated at average exchange rates during the period, and assets and liabilities are translated at the unified exchange rate as quoted by the People's Bank of China at the end of the period. Equity transactions are recorded at their historical amounts. Translation adjustments resulting from this process are included in accumulated other comprehensive income in the statement of stockholders' equity. Transaction gains and losses that arise from exchange rate fluctuations on transactions denominated in a currency other than the functional currency are included in the results of operations as incurred. For the nine months ended February 29, 2016 and February 28, 2015, a foreign currency gain (loss) of $(1,658,678) and $5,585, respectively, have been reported as other comprehensive income in the consolidated statements of income and other comprehensive income. The foreign currency loss was mainly due to the devaluation of the Chinese currency by approximately 3.5%.
 
Liquidity and Capital Resources
 
As of February 29, 2016, we had cash and cash equivalents of $6,639,055, primarily consisting of cash on hand and demand deposits. The cash balance was principally derived from cash from operations.

To date, we have financed our operations primarily through cash flows from operations. We believe that our cash on hand and cash flows from operations will meet our present cash needs for the next 12 months.

Operating activities
 
Net cash used in operating activities was $(5,645,299) for the nine months ended February 29, 2016, as compared with the net cash provided by operating activities of $2,777,229 for the nine months ended February 28, 2015. For the nine months ended February 29, 2016, the increase in the accounts receivable of $11,140,077 and the increase in security deposit payable of $2,075,360 mainly caused the difference between the net cash used by operating activities and the net income.  For the nine months ended February 28, 2015, the net income and the increase in deferred revenue of $292,950 principally provided the cash operating activities.
 
Investing activities
 
We spent $12,803,897 and $0 for the nine months ended February 29, 2016 and February 28, 2015, respectively, for equipment purchases. The increase for the nine months ended February 29, 2016 was principally due to the purchase of garbage processing equipment of approximate $12,860,000 which we are currently leasing under an operating lease.
 
Financing activities
 
For the nine months ended February 29, 2016 and February 28, 2015, we did not have any cash provided or used by any financing activities.
 
Effect of exchange rate on cash

The negative effect of the exchange rate on cash of $(1,285,128) was principally due to the devaluation by the PRC government of their currency. There could be further negative adjustments should the PRC government or the exchange markets further devalue the Chinese currency.

40

Off-Balance Sheet Arrangements

We do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition or results of operations.
 
Transfer of Cash
 
All of our revenues are earned by Jiangsu Xuefeng, our PRC controlled consolidated affiliate. PRC regulations restrict the ability to make dividend and other payments to its offshore parent company. PRC legal restrictions permit payments of dividends only out of accumulated after-tax profits, if any, determined in accordance with PRC accounting standards and regulations. Our PRC entities also required under PRC laws and regulations to allocate at least 10% of their annual after-tax profits determined in accordance with PRC GAAP to a statutory general reserve fund until the allocation reaches 50% of its registered capital. The statutory reserve fund can only be used for specific purposes and is not transferable to us in the form of loans, advances or cash dividends. Any limitations on the ability of our entities to transfer funds could materially and adversely limit our ability to grow, make investments or acquisitions that could be beneficial to our business, pay dividends and otherwise fund and conduct our business.

Lotus International Holdings Limited, a Hong Kong corporation and Baichuang Information Consulting (Shenzhen) Co., Ltd, a WFOE, is a bridge to transfer funds inside and outside the PRC. There are three ways for foreign cash to be transferred into Chinese subsidiaries:

(1) Capital funds: At the establishment of the WFOE (Baichuang Consulting), in accordance with the provisions of PRC Foreign-Owned Enterprise Law, funds were injected as capital by Lotus International into the WFOE.

(2) Raised capital - acquisition: if the Company raised sufficient capital, it could transfer the capital to Jiangsu Xuefeng by causing Lotus International (HK company) to apply to the Chinese Ministry of Commerce (MOFCOM) for approval of an acquisition of Jiangsu Xuefeng by Lotus International. MOFCOM would approve such an acquisition only after a lengthy review process, and only if it determined that the price paid by Lotus International for Jiangsu Xuefeng represented a commercially fair price.

(3) Raised capital - joint venture: Lotus International could inject the funds into Jiangsu Xuefeng by complying with the provisions of the PRC Sino-Foreign Equity Joint Venture Law. To accomplish this capital transfer, we would be required to apply to the Chinese government for approval to convert Jiangsu Xuefeng into an equity joint venture, in which Lotus International would be its equity joint venture. If approved, Lotus International would then own a portion of the equity in Jiangsu Xuefeng, and the VIE agreements between Jiangsu Xuefeng and Baichuang Consulting (WFOE) would be modified accordingly to reduce the portion of net income payable by Jiangsu Xuefeng to Baichuang Consulting.

We have no current plans for the Company to fund Jiangsu Xuefeng and expect the VIE structure to remain in place for the foreseeable future.

Pursuant to the Exclusive Technical Service and Business Consulting Agreement between Baichuang Consulting (WFOE) and Jiangsu Xuefeng, Baichuang Consulting is to provide technical support and consulting services to Jiangsu Xuefeng in exchange for (i) 95% of the total annual net income of Jiangsu Xuefeng and (ii) RMB100, 000 per month (approximately US$16,000). As a result, there are also two ways to transfer the funds from inside the PRC to outside the PRC: 

 (1) According to the provisions of the Service Fee in Article 3 of the Exclusive Technology Service and Business Consulting Agreement, 95% of the net income of Jiangsu Xuefeng will be paid to Baichuang Consulting as a service fee, and in turn Baichuang Consulting will in compliance with the provisions of PRC Foreign-Owned Enterprise Law, transfer this income to Lotus International for the purpose of profit distribution. 

(2) In addition, Article 3 of the Exclusive Technology Service and Business Consulting Agreement requires that a management fee of approximately $16, 000 U.S. will be paid to Baichuang Consulting each month, and in turn Baichuang Consulting will be in compliance with the provisions of the PRC Foreign-Owned Enterprise Law and transfer this income to Lotus International for the purpose of profit distribution. 

The earnings and cash transfer procedures are all designed to comply with PRC regulations. As a result, there will be no government regulations which will impact our transactions to transfer cash within our corporate structure. However, when the funds are transferred outside the PRC, all transferred amounts will be reported to the national tax bureau to examine whether the local and national taxes have been fully paid by Jiangsu Xuefeng and Baichuang Consulting. In addition, should such cash transfer go to the U.S. parent company, it would be taxable, The Company presently has no plans to transfer cash outside the PRC and intends to indefinitely reinvest such undistributed earnings of its foreign subsidiaries. Accordingly, there is no U.S. provision on these earnings.
 
41

Recent Accounting Pronouncements

In February 2016, the FASB issued Accounting Standards Update No. 2016-02, Leases. The new standard establishes a right-of-use ("ROU") model that requires a lessee to record a ROU asset and a lease liability on the balance sheet for all leases with terms longer than 12 months. Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition in the income statement. The new standard is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. A modified retrospective transition approach is required for lessees for capital and operating leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements, with certain practical expedients available. This accounting standard update is not expected to have a material impact on the Company's financial statements.

In January 2016, the FASB issued ASU No. 2016-01, Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities. The updated guidance enhances the reporting model for financial instruments, which includes amendments to address aspects of recognition, measurement, presentation and disclosure. The update to the standard is effective for the Company beginning June 1, 2018. The Company is currently evaluating the effect the guidance will have on the Consolidated Financial Statements.

In August 2015, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") 2015-14, Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date. The amendment is effective for all entities for fiscal years and interim periods within those fiscal years, beginning after December 15, 2017. Earlier application is permitted only as of annual reporting periods beginning after December 15, 2016, including interim reporting periods within that reporting period. The Company is evaluating the impact of this standard on its Consolidated Financial Statements.

In March 2015, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") ASU 2015-03 – Interest – Imputation of Interest (Subtopic 835-30). This ASU addressed the simplification of debt issuance costs presentation by presenting debt issuance costs in the balance sheet as a direct deduction from the carrying amount of debt liability, consistent with debt discounts or premiums. For public business entities, the amendments in this Update are effective for financial statements issued for fiscal years beginning after December 15, 2015, and interim periods within those fiscal years. This accounting standard update is not expected to have a material impact on the Company's consolidated financial statements.

In January 2015, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") ASU 2015-01 – Income Statement – Extraordinary and Unusual Items (Subtopic 225-20).  This ASU addressed the simplification of income statement presentation by eliminating the concept of extraordinary items.  The objective of the Simplification Initiative is to identify, evaluate, and improve areas of generally accepted accounting principles (GAAP) for which cost and complexity can be reduced while maintaining or improving the usefulness of the information provided to the users of financial statements.  The amendments in this update are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. A reporting entity may apply the amendments prospectively.  A reporting entity also may apply the amendments retrospectively to all prior periods presented in the financial statements.  Early adoption is permitted provided that the guidance is applied from the beginning of the fiscal year of adoption.  This accounting standard update will not have a material impact on the Company's consolidated financial statements.

In August 2014, the FASB issued authoritative guidance that requires an entity's management to evaluate whether there are conditions or events, considered in the aggregate, that raise substantial doubt about the entity's ability to continue as a going concern and requires additional disclosures if certain criteria are met. This guidance is effective for fiscal periods ending after December 15, 2016, with early adoption permitted. This accounting standard update is not expected to have any impact on the Company's financial statements.

Critical Accounting Policies

The Company does not currently have any estimates that it believes could materially affect its financial position or results of operations in the future.

The critical accounting policy that could have a material effect on the Company's financial statements is the determination that the Company is the primary beneficiary of Jiangsu Xuefeng, its VIE.  Should this determination change or the VIE agreements become not in compliance or enforceable under PRC law, it could result in the deconsolidation of the VIE.

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

Interest Rate Risk

Changes in interest rates may affect the interest earned and therefore affect our cash flows and results of operations. However, we do not believe that this interest rate change risk is significant.

42

Currency Exchange Fluctuations

All of the Company's revenues are denominated in Chinese Renminbi, while its expenses are denominated primarily in Chinese Renminbi ("RMB"). The value of the RMB-to-U.S. dollar and other currencies may fluctuate and is affected by, among other things, changes in political and economic conditions. Since 1994, the conversion of Renminbi into foreign currencies, including U.S. dollars, has been based on rates set by the People's Bank of China ("PBOC"), which are set daily based on the previous day's inter-bank foreign exchange market rates and current exchange rates on the world financial markets. Since 1994, the official exchange rate for the conversion of Renminbi to U.S. dollars had generally been stable and the Renminbi had appreciated slightly against the U.S. dollar. However, on July 21, 2005, the Chinese government changed its policy of pegging the value of Chinese Renminbi to the U.S. dollar. Under the new policy, Chinese Renminbi may fluctuate within a narrow and managed band against a basket of certain foreign currencies. Recently there has been increased political pressure on the Chinese government to decouple the Renminbi from the United States dollar. At the recent quarterly regular meeting of PBOC, its Currency Policy Committee affirmed the effects of the reform on Chinese Renminbi exchange rate. Since February 2006, the new currency rate system has been operated; the currency rate of Renminbi has become more flexible while basically maintaining stable and the expectation for a larger appreciation range is shrinking. In August 2015, the PRC government devalued its currency by approximately 3.0%. The Company has never engaged in currency hedging operations and has no present intention to do so.
 
Country Risk

A substantial portion of our assets and operations are located and conducted in PRC. While the PRC economy has experienced significant growth in the past twenty years, growth has been uneven, both geographically and among various sectors of the economy. The Chinese government has implemented various measures to encourage economic growth and guide the allocation of resources. Some of these measures benefit the overall economy of China, but may also have a negative effect on us. For example, our operating results and financial condition may be adversely affected by government control over capital investments or changes in tax regulations applicable to us.  If there are any changes in any policies by the Chinese government and our business is negatively affected as a result, then our financial results, including our ability to generate revenue and profits, will also be negatively affected. Economic growth in the PRC has recently begun to slow.
 
Item 4Controls and Procedures.

Evaluation of Disclosure Controls and Procedures

Pursuant to Rule 13a-15(b) under the Exchange Act, the Company carried out an evaluation, with the participation of the Company's management, including the Company's Chief Executive Officer ("CEO") and Chief Financial Officer ("CFO") (the Company's principal financial and accounting officer), of the effectiveness of the Company's disclosure controls and procedures (as defined under Rule 13a-15(e) under the Exchange Act) as of the end of the period covered by this report. Based upon that evaluation, for the reasons set forth below, the Company's CEO and CFO concluded that the Company's disclosure controls and procedures were not effective as of February 29, 2016 to ensure that information required to be disclosed by the Company in the reports that the Company files or submits under the Exchange Act, is recorded, processed, summarized and reported, within the time periods specified in the SEC's rules and forms, and that such information is accumulated and communicated to the Company's management, including the Company's CEO and CFO, as appropriate, to allow timely decisions regarding required disclosure.
 
A material weakness is a deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the Company's annual or interim financial statements will not be prevented or detected on a timely basis. In its assessment of the effectiveness of internal control over financial reporting as of February 29, 2016, the Company determined that there were control deficiencies that constituted the following material weaknesses:

The Company does not have a sufficient number of accounting personnel, which would provide segregation of duties within our internal control procedures to support the accurate and timely reporting of our financial results.
 
 
The Company's current accounting personnel lack experience and knowledge in identifying and resolving complex accounting issues under U.S. Generally Accepted Accounting Principles (GAAP).

Changes in Internal Control over Financial Reporting

No change in our system of internal control over financial reporting occurred during the period covered by this report that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.  
 
43


PART II—OTHER INFORMATION

Item 1. Legal Proceedings.

From time to time, we may become involved in litigation relating to claims arising out of its operations in the normal course of business. We are not involved in any pending legal proceeding or litigation and, to the best of our knowledge, no governmental authority is contemplating any proceeding to which we are a party or to which any of our properties is subject, which would reasonably be likely to have a material adverse effect on us.

Item 1A. Risk Factors.

There are no material changes to the risk factors as set forth in the Annual Report on Form 10-K filed with the SEC on August 31, 2015.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.

None.

Item 3. Defaults Upon Senior Securities.

None.

Item 4. Mine Safety Disclosures.

Not applicable.

Item 5. Other Information.

None.
 
Item 6. Exhibits.

Exhibit No.
 
Description
 
 
 
31.1
 
Certification of Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
 
 
 
31.2
 
Certification of Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
 
 
 
32.1+
 
Certification of Principal Executive Officer of the Company, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
 
 
32.2+
 
Certification of Principal Financial Officer of the Company, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
 
 
101.INS
 
XBRL Instance Document
 
 
 
101.SCH
 
XBRL Taxonomy Extension Schema Document
 
 
 
101.CAL
 
XBRL Taxonomy Extension Calculation Linkbase Document
 
 
 
101.DEF
 
XBRL Taxonomy Extension Definition Linkbase Document
 
 
 
101.LAB
 
XBRL Taxonomy Extension Label Linkbase Document
 
 
 
101.PRE
 
XBRL Taxonomy Extension Presentation Linkbase Document

+In accordance with SEC Release 33-8238, Exhibits 32.1 and 32.2 are furnished and not filed. 
 
44

 

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, there unto duly authorized.

 
China Xuefeng Environmental Engineering Inc.
 
 
 
 
 
 
 
 
 
Date: April 14, 2016
By:
/s/ Li Yuan
 
 
 
Li Yuan
 
 
 
Chief Executive Officer
 
 
 
(Duly Authorized Officer and Principal Executive Officer)
 
 
 
 
 
 
 
 
 
Date: April 14, 2016
By:
/s/ Kuanfu Fan
 
 
 
Kuanfu Fan
 
 
 
Chief Financial Officer
(Duly Authorized Officer and Principal Financial Officer)
 
 
 
 
45